The biggest game of tug of war this fall isn't being played at a corporate retreat or fraternity party. It's being played on Wall Street, between the stock and bond markets. For each of the past six weeks, stocks have risen—a sure sign that investors believe the soft patch of the summer is safely behind us and that the future looks rather bright. Meanwhile, the yields on the 10-year U.S. government bond have fallen sharply from about 4.6 percent in late July to about 4.1 percent today, a sure sign that bond investors believe the consumer-driven economy is running out of steam. (Here is a six-month chart of the 10-year bond.)
Investors in stocks and bonds view the world differently. Bond investors tend to be suspicious and pessimistic by nature. They accept lower potential gains in exchange for lower potential losses. Bonds guarantee at least an interest payment, and government bonds are backed by the full faith and credit of the most powerful nation in world history. Stock investors are by nature optimistic, even credulous. Stocks are about stories, future growth, and earnings estimates. They are backed only by the full faith and credit of highly fallible CEOs.
So it's natural that there would be some disconnect between the two groups. But the two markets usually have roughly the same view of the economy. Crudely speaking, when the economy is running hot, you'd expect the prices of stocks to rise and the prices of bonds to fall. When it's sputtering along, you'd expect the prices of bonds to rise and the prices of stocks to fall. Today, however, the bond and stock markets seem to inhabit different worlds. They are about as polarized as the American electorate.
Think of the bond investors as Kerry supporters. The recent action in the 10-year bond shows that bond investors are gloomy on economic growth. The dollar remains weak against many currencies, the Federal Reserve is boosting short-term rates, and the prices of commodities such as steel and oil have been rising. With the economy having expanded at just a 2.8 percent rate in the second quarter, economists, like those surveyed by the Philadelphia Federal Reserve Bank, have ratcheted down their estimates for Gross Domestic Product growth in the second half of 2004. By taking long-term market rates down even as the Federal Reserve has been pushing short-term interest rates up, bond investors are collectively arguing that the best days of growth are behind us. And they're predicting that the GDP figures may continue to disappoint.
Based on that same data, you'd expect stocks to decline. If the economy's rate of growth were slowing—and if short-term interest rates and commodity prices were rising—companies would be unlikely to increase profits. Indeed, corporate profits grew at a remarkably slow rate in the second quarter. And since stocks represent a claim on a company's future earnings, you would expect that the combination of higher short-term rates and slower growth—and hence slower profit growth—would prove to be a major downer for the stock market.
But these stock investors, like Bush supporters, remain defiantly, perhaps inexplicably optimistic. Despite the rash of earnings warnings and disappointment from large consumer-oriented companies, stocks are doing pretty well. Resolute investors have generally shrugged off earnings warnings as a temporary byproduct of the summer's evanescent soft patch. And the bad news has been tempered by good news from steel manufacturers, home-builders, oil companies, and some technology companies. To justify current prices—and to push them higher—stock investors must believe that the pace of the economy's growth is accelerating, not declining, and that the climate is ripe for companies to increase their profit margins.
So there are currently two distinct views of the economy on display on Wall Street. In one, economic growth is slowing, consumers are highly leveraged and exhausted, short-term interest rates are rising, and inflationary pressures will tamp down earnings growth. In the other, the economy is strong and getting stronger, businesses are confident, and we're back to the blessed combination of cheap long-term money and solid growth. The stock investors and bond investors can't both be right. At some point, one of these teams will find itself tumbling into the mud pit.